The Psychology of a $225 Million Mistake
When experience keeps a dear school: A retrospective on FTX
Let's examine how the world's most successful venture capital partnership lost $225 million in what turned out to be nothing more than a sophisticated confidence game.
The Great Crypto Scandal of 2022
I’m going to tell you a story about a great investment scandal of our time, one that might have been prevented if human nature weren't allowed its full expression.
Our scene opens in Silicon Valley, the legendary cradle of technological innovation, in lush offices on Sand Hill Road. The partners at one of the world's most successful venture capital firms are gathered for their weekly investment committee meeting. But trouble is brewing, annual returns have grown so extraordinary that a dangerous overconfidence has taken root.
The year is 2021, and cryptocurrency has taken the world by storm. Bitcoin has reached new highs, Coinbase - the cryptocurrency exchange - has gone public at a staggering valuation, and the partners are feeling the pressure of missing out on what seems to be the greatest technological revolution since the internet.
Into this scene comes a young man named Sam Bankman-Fried, or SBF as he's known in crypto circles. SBF runs a cryptocurrency exchange called FTX that's growing faster than any financial company in history.
He has crafted himself as the perfect specimen for the time: an MIT physics graduate, committed to effective altruism, sleeping on a beanbag in his office, and speaking the complex language of quantitative finance with the casual brilliance that Silicon Valley finds irresistible.
Now, I want you to focus carefully on the psychological forces that will soon create what I call a "lollapalooza effect" of misjudgment. Remember, this is a partnership that helped build Apple, Google, and other titans of technology. They are smart people. No doubt. But they are human, and therefore subject to the same psychological tendencies that have been causing financial disasters since the Dutch went mad over tulip bulbs in 1637.
First comes social proof, that powerful force that Cialdini documented so well in his work on influence. When you see BlackRock, Tiger, SoftBank, and other prestigious firms clamoring to invest, it creates an almost irresistible pull. The human mind is wired to look to others for guidance on behavior, particularly in uncertain situations, and the partners of the world’s top fund are no exceptions. The same tendency that makes teenagers want to wear what their friends are wearing is now making sophisticated investors want to invest where their peers are investing.
Next we have authority bias combining with the halo effect. Here is a young genius from MIT, speaking the language of high finance, who had already made millions in arbitrage trading at Alameda Research. When someone looks and sounds like the authority figure we expect, our critical thinking often goes on vacation. The same psychological tendency that makes us inherently trust a person in a doctor's coat is now making intelligent people trust a disheveled billionaire in cargo shorts.
Add to this toxic mix the contrast effect. When you're seeing hundreds of investment pitches a year, someone dramatically different becomes irresistible. SBF's apparent genius, his commitment to giving away his fortune, his seemingly revolutionary business model. All of these stand in stark contrast to the typical founder pitch.
But now comes the most dangerous force of all: the fear of missing out, turbocharged by the incentive structure of venture capital. You see, in venture capital, missing the next Google is often more career-threatening than losing money on a bad investment. Cryptocurrency was creating enormous wealth at breathtaking speed. The fear of missing "the next big thing" became overwhelming.
The investment committee runs through their standard checklist: "What about the financials?" asks one partner.
"They're incredible," comes the reply. "Growing faster than Google."
"And compliance?"
"They've got a whole team working on it."
"What about the board of directors?"
"Well, that's different in crypto. It's all about moving fast and disrupting traditional structures."
Notice how easily intelligent people can rationalize away red flags when their minds are clouded by the lollapalooza effect of multiple psychological tendencies working together? Like a chemical reaction where the combination is far more potent than the sum of its parts, these cognitive biases combine to create a perfect storm of misjudgment. It’s especially risky when past success has created a dangerous overconfidence bias, which can lead to decreased vigilance.
But the decision is made. The partnership invests $225 million. Once committed, they fall prey to what psychologists call commitment and consistency bias, even publishing a glowing profile of their young genius. The human mind abhors admitting error and now, to protect themselves from having to admit mistakes, they won’t look for disconfirming information. Changing one's mind in the face of new information is surprisingly difficult, so we tend not to look for it.
The fall came swiftly in November 2022. FTX’s $32 billion empire collapses in days. Customer funds are missing. The autopsy reveals a company with no board of directors, no proper accounting, and no internal controls. The same partnership that once conducted months of due diligence had thrown their playbook out the window when it came to crypto, and soon wrote down their entire investment to zero.
Even a prestigious firm, with all the resources and experience in the world, can fall victim to this confluence of psychological forces. In this case, the soft biases of the human mind overcame the hard-won wisdom of decades of venture investing.
What lessons can we draw?
First, remember that nobody is immune to psychological weaknesses. Not even the most sophisticated investors.
Second, beware of the new thing that everyone says will change everything. As Mark Twain observed, "History doesn't repeat itself, but it often rhymes."
Third, never underestimate the power of incentives. When fear of missing out combines with other psychological tendencies and a 20% carry, otherwise sensible people can make remarkably foolish decisions.
Fourth, maintain your skepticism, especially when everyone else is abandoning theirs. As Charlie Munger always said, "It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent."
And finally, remember that there's no such thing as a new era that makes traditional business principles obsolete. The need for proper governance, controls, and accountability remains constant.
The lessons here aren't about cryptocurrency, venture capital or due diligence. They’re about the eternal vulnerability of human judgment to these psychological tendencies.
The human mind has evolved little since our ancestors roamed the savannah. The only defense is to study these tendencies, recognize them in ourselves and others, and build institutional safeguards against them. Otherwise, we're doomed to repeat the same mistakes, just with fancier technologies and bigger numbers.
Let's be rational about this:
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